The Euro Downgrades’ Ripple Effects

By Jonnelle Marte

As investors brace for more stormy markets ahead following the unprecedented string of ratings downgrades that hit Europe last week, advisers say there are ways they can minimize the impact on their portfolios.

Standard & Poor’s stripped France of its triple-A long-term credit rating Friday, as part of a series of ratings actions taken on 16 euro-zone countries. Austria also lost its triple-A status and S&P lowered the ratings on Cyprus, Italy, Portugal and Spain by two notches, among other moves. But it’s the downgrade of Europe’s second-largest economy, France, many pros said was most significant. In fact, some analysts expressed a small amount of relief that France’s downgrade was one notch, and not far worse.

To be sure, market watchers say investors have been expecting the ratings action since S&P put 15 of the 17 euro-zone countries on watch for possible downgrades in December, including, the Netherlands, Austria, Finland and Luxemburg. And while the downgrades have rippled throughout the markets, causing the euro to drop, stocks to sell off and European bond yields to soar, advisers say much of the bad news has already been priced in.

Even so, advisers say investors are rightly concerned. Here are some of the likely consequences for investors in particular — and the portfolio moves that experts say might be warranted.

Bonds

Yields on Spanish, French and Italian bonds rose on the news that S&P could lower the ratings of several countries, which pushed the yield difference between French bonds and safer German bunds up by 0.1 percentage points. But any further yield increases are unlikely because many investors feel the worst case scenario—the risk that France could have been downgraded two notches—has been avoided, says Brendan Murphy, director of global fixed income for Standish Asset Management. That said, demand for Italian and Spanish bonds is likely to remain weak over the next couple of months, and yields are likely to stay high, while investors wait for more stable signs of a resolution of the debt crisis, says Popplewell.

The impact is likely to be softened by the European Central Bank, which has been stepping in to buy Italian and Spanish bonds when yields rise too sharply, says Ted Bovard, an adviser at Pittsburgh-based Fort Pitt Capital Group. “As long as the ECB is in there buying those bonds I don’t think we’re going to see a significant effect,” Bovard says of the downgrade. Murphy, like Bovard, is limiting exposure to Treasurys because yields are too low, preferring instead to hold high quality investment grade bonds, which pay more attractive yields but also come with low credit risk. Murphy says he might increase exposure to riskier high yield bonds if risks of a global recession come down: “We’re wading in, we’re not going all in–in terms of adding risk,” he says.

Currencies

Investors would be smart to cut exposure to the euro, which is expected to keep declining, says Dean Popplewell, chief currency strategist for Oanda Corp., a forex data provider. While the euro dropped down as low as $1.26 Friday from $1.28 late Thursday following news of the downgrade, the common currency could sink even further in 2012 as worries over Europe persist, says Popplewell. The European Central Bank could continue cutting interest rates in an effort to spur the economy, but such moves are not enough to help investors regain confidence in the European economy, he adds.

Popplewell says he plans to short the euro and move into currencies like the Canadian dollar, Norwegian krone and Brazilian real, which he believes should gain against the euro if economic growth in the United States begins to pick up. The greenback should also benefit against the euro, but at a slower pace, he says. If investors begin to fear the U.S. economy is slowing down, the U.S. dollar might outperform those other currencies as investors around the world pile into the safe haven dollar, he says. Popplewell warns against moving into other traditional safe havens, like the Japanese yen or Swiss franc, because their governments are intervening to keep them from appreciating.

Stocks

Market watchers say it’s not clear the downgrades will lead to a long-term slump in global stocks. Many investors are already defensive when it comes to their stock holdings, so they may not feel the need to cut back their exposure following the news, experts say. Bovard, for example, is staying pat on his equity allocations. Already hurt by disappointing earnings and reports of potential cut backs, bank stocks could take another beating because of the downgrades, experts say. Investors have been shying away from U.S. banks, concerned about their exposure to Europe, says Bovard, and that hesitation could continue until concerns over the European debt crisis calm down.

Bovard recommends investors put more emphasis on emerging-market stocks, where countries often have higher economic growth than some developed regions. For those hoping to buy European stocks, a focus on countries like Germany and France “may be better bets at this time,” says Bovard. Advisers also recommend investors stick with dividend-paying stocks which can boost returns in today’s volatile markets. And for those feeling opportunistic, there might be bargains in bank stocks, experts say.

Comments (0)

About Real-Time Advice

How breaking news — in the markets, Washington, and around the world — affects you and your money. Have a question about how current events may change your financial future? Email us at ask@smartmoney.com.